Royalties are the income you can make off your name, product or invention under the terms of a licensing agreement. The operative word is "terms," and every licensing agreement can have different terms. If the terms of the licensing agreement pay you based on a percentage of net income, and the company has no net income, your percentage is zero. However, if your terms are based on sales, you're guaranteed a percentage of sales regardless of how the company computes net income. The most important aspect of negotiating terms is to know the right questions to ask. The second-most important aspect is being able to walk away if you don't get the right answer.
Contrary to popular belief, companies have considerable latitude in calculating net income. Moreover, a company is at liberty to do whatever it wants to improve operations, including increasing wages, increasing marketing expense, investing in new or more expensive inventory, or even purchasing a new building. These can be one-time expenses that erode net income for one quarter or for an entire year. Sales on the other hand, is a firm calculation. While they may include discounts and/or coupons, sales are firm and cannot be adjusted or manipulated.
To better gauge the potential sales opportunity from your agreement, it's best to ask the company for a sales forecast and the price for which it plans to sell the product. For example, assume the company is paying you royalties based on the use of your name. If the company sells 500 units per month without the use of your invention or name, and it expects to sell 100 more units with the use of your name, the sales unit forecast is 600.
Another important aspect of an royalty agreement is pricing. Your terms should include a fair market price for the product as well as an increase in price for the use of your invention or name. For example, if the company plans on selling the product for $10, which is $2 more than it sold it for without the use of your name, the sales forecast is calculated by multiplying the intended number of units to be sold by the sales price, or $6,000.
Even a high royalty percentage is no guarantee of income. Additionally, depending on the type of royalty, it is quite possible that the company may never use your contribution and therefore never owe you a dime. For this reason, it is not uncommon for royalty agreements to include a guaranteed minimum payout.